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Ideas Farm: Lockdown’s broken promises

Everyone is prone to misunderstand growth trends and investors can turn that to their advantage
Ideas Farm: Lockdown’s broken promises
  • What happened to all those lockdown winners?
  • ... Oh My Gosh! That's horrid.
  • Some profitable lessons to learn.
  • Loads of new ideas generating data.

Lockdowns are coming into force once more in some parts of Europe. But on the stock market, lockdown seems a distant memory for many of the shares that were set alight by the onset of the pandemic.

In the US, shares in the likes of video-conferencing firm Zoom (US:ZM) and exercise-bike company Peloton (US:PTON) are off their highs by 65 per cent and 73 per cent, respectively. 

Closer to home, online white-goods retailer AO World (AO.) is down 76 per cent from its January peak. That peak followed a 767 per cent ascent from the start of 2020 to those early 2021 high. Meanwhile, Best of the Best (BOTB), a spot-the-ball-to-win-a-car competition operator, has tumbled 83 per cent since March. It clocked a near 10-fold rise from the start of 2020 to its high while amassing an army of private-investor fans. And the list of fallen lockdown stars could go on... and on.

What the heck has happened?

The most likely answer is that we’ve simply seen a rather extreme case of deep-rooted human behaviour at work. The behaviour in question being our tendency to over-extrapolate very pronounced, short-term trends. Our brains are extremely predisposed to do this. 

Nobel prize winning behavioural psychologist Daniel Kahneman labels the host of psychological traits that spawn such myopic reasoning as “What You See Is All There Is”. Essentially, we find it very hard to correctly contextualise recent, attention-grabbing events. We get sold on narratives that suggest strong performance can continue and have an uncanny habit of finding evidence to support the case while ignoring arguments to the contrary.

This gets investors into all sorts of trouble, especially where growth stocks are concerned. We presume a short period of exceptional growth is representative of the future when it isn’t. This is also often cited as a reason for the long-term underperformance of the growth-focused Aim market. 

But there are two other aspects connected to our habit of misunderstanding growth trends that can help investors profit from psychological foibles as opposed to just trying to avoid losses.

When we do alight on real long-term growth trends, we actually have a tendency to underappreciate them. We think about growth as linear rather than exponential. The great Swedish physician and data-visualisation pioneer Hans Rosling described this as “the straight line instinct”. 

In the real world, success often builds on success. The profits of truly great companies tend to snowball, with each year's growth building from a larger base. We get an upward sloping curve rather than a straight line. 

Entrepreneur and author Peter Diamamdis uses a great thought experiment to demonstrate just how mind-boggling this kind of exponential growth is. Leaving our house and taking 30 “linear” one-meter steps from our front door takes us 30 meters. But taking 30 exponential steps, where our stride starts at a meter but doubles each step, would take us 26 times around the planet. 

Translating this concept into pounds rather than steps: find a company with sustainable, high returns on capital and a genuine long-term growth prospect, and it is more than likely going to be undervalued. That said, finding such a beast is extremely rare. And harking back to the point about fallen lockdown stars, our default is to be too ready to believe we’ve found the fabled beast while also underappreciating it if we actually do. 

Perhaps the easier way to profit from our tendency to misunderstand trends is from the approach used by so-called value investors. Just as we think good news will never stop flowing, when news is bad, our instinct is to think it will always be that way. 

Sometimes instinct is right. However, with diligent research, we can sometimes identify situations where there is hope for a better future that the market is overlooking. Some of lockdown’s hero-to-zero stocks may be worth exploring from that perspective now.